A blog of the NYU Colloquium on Market Institutions and the Leipzig Colloquium on the Market Order

Market Regulation

Benjamin M. Friedman wrote a review essay for the New York Review of Books on the crisis of the economy and the economics profession. In an otherwise very good piece, he took an obligatory swipe at deregulators: “There is a long arc from Roosevelt’s acceptance of a useful role for government institutions and government regulation to the conviction of Reagan and Thatcher that the government is never the solution but actually the problem” (p. 43). That is a straw man all around, but one promoted by textbook presentation of markets and the equilibrating role of prices.

Prices are the self-regulating mechanism in textbook presentations. If prices fail to perform that function (e.g., for public goods or externalities), then there is market failure and a role for regulation. As in Friedman’s characterization, “regulation” means government intervention. Each step in the argument must be questioned: from failure to regulation to government intervention.

That textbook treatment abstracts from the rich array of institutions under-girding actual markets. First, there is an entire array of institutions summarized by the “rule of law” or the “legal framework. Next, there are a myriad of structures, customs and practices that regulate behavior in markets. There both formal and informal institutions at work. The price system is indispensable for allocating resources. But prices are not sufficient for the purpose.

Lee Hoskins and I made “The Case for Market-Based Regulation” . We built on the UCLA property rights tradition, particularly the work of Armen Alchian; and on the Austrian tradition, particularly Menger and Hayek. We provided numerous examples of regulating practices and institutions evolved spontaneously and treated them part of the larger market process. We also noted that as government takes over the regulating function, market institutions recede. The paper was written before the current crisis, but with the financial system very much in mind. “Safety-and-soundness practices based on market incentives and clearinghouse rules have been replaced by government regulations, central banks, and deposit insurance” (p. 478).

To return to Friedman’s observation, is he suggesting that governments are self-regulating in a way superior to markets? That is a heavy burden to carry. And in terms of the current financial and economic crisis, there was an elaborate complex of government regulations and agencies enforcing them that failed systematically to prevent the crisis.

“Prices are the self-regulating mechanism in textbook presentations. If prices fail to perform that function (e.g., for public goods or externalities), then there is market failure and a role for regulation.”

I assume that those were your words and thoughts rather than Mr Friedman’s, and that your thought is that there is a role for an institution outside the market, the state, forcing itself upon it.

Perhaps the best example of something warranting that would be the environment. Even in the purest free market, nobody could own it. It would be a common good the value of which could not be priced but must still be paid for.

And who but the state could see to that?

The free market, that’s who.

In a completely free market, there would be no more public communities, such as the City of Los Angeles, the State of California, nor United States of America. There would be the private Los Angeles, Burbank, and Van Nuys Land Holding Companies, or California and Nevada Land Holding Companies, or American and Mexican Land Holding Companies.

No one of those private land holding companies could own the whole environment, nor, by itself, protect its own part of it from the pollution migrating to it from other parts of it. The protection of any part of the environment requires the cooperation of the owners of every part of it.

How to achieve that cooperation, through an overarching state enforcing it or the voluntary efforts of all the separate private companies?

Here we get into what I believe you would call Public Choice Theory, a theory of psychology and politics, taking up where economics leaves off, and which is, ultimately, a theory of public vs. private choice, and of war vs. peace.

Could the free market solve its problem peacefully? It certainly has an incentive to do so. Private businesses don’t want war, for it’s bad for business.

And, likewise, what’s bad for its environment is bad for the business of a private land holding company. It has a business incentive to protect its own environment, and, in the process, the environment of others. It cannot be indifferent to the pollution that it exports, for the smoke from its factories pollutes its own air more than that of others.

And even if there were somehow economic gains from exporting pollution, there would be losses as well. And even were there a net gain, and no free market solution to the problem, there would still be the option of war. But why assume the necessity of it? Why not at least give the free market and peace on Earth a chance?

Is there any chance for it within a world of nation-states? Yes, but only when, as in the 19th Century, they were largely dedicated to the principles of the free market. But, ultimately, war — class, race, trade, and shooting – is the stock in trade of statesmen. They are war-mongers by necessity, and the choice of public over private choice is for war over peace.

While private businesses need solutions to their problems, the state needs the problems. And the last thing that those with a mutual self-interest in resolving them need is interference from those living off of them, and with a mutual self-interest in endless disputes over them.

There no guarantee that the free market would solve its problems, but does it make any sense not to give it the chance?